Chapter 14 The exchange rate

Lecture Plan Exchange rates: definition and brief Australian history Effects of currency appreciation/depreciation on Australia’s foreign trade Determination of exchange rates Terms of trade changes: causes and effects 2

Foreign Exchange Rates Exchange rate = The price of one currency in terms of another, e.g. A$1 = US$0.7500, or US$1 = A$1.3333 Appreciation/depreciation Trade-weighted index (TWI) May 1970 = 100 June 1994: 53.0 January 1998: 61.9 September 2001: 47.0 October 2003: 61.0 3

The Australian Exchange Rate Fixed exchange rates Pegged to the Pound sterling (prior to December 1971) Pegged to the US dollar (December 1971 to September 1974) Pegged to a TWI (September 1974 to November 1976) Managed float (TWI + Government): November 1976 to December 1983 Independently floating exchange rates: Since December 1983, with some RBA intervention (‘the dirty float’)

Relationship Between Fixed Exchange Rates, BOP and Money Supply Fixed exchange rate of the A$ Balance of payments (BOP) effect Money supply volume Under equilibrium SURPLUS Above equilibrium DEFICIT

Effects of A$ Appreciation/ Depreciation on Imports Computer import price (US$/tonne): US$1500 Exchange Rate (A$1 = …) Australian importer pays Exchange rate effect ( + / – ) US$0.75 A$2000 US$0.90 A$1600 – A$400 (– 17%) US$0.60 A$2500 + A$500 (+ 25%)

Effects of A$ Appreciation/ Depreciation on Exports Beef export price (US$/tonne) = US$1000 Exchange rate (A$1 = …) Australian exporter receives Exchange rate effect ( + / – ) US$0.75 A$1333 US$0.90 A$ 1111 – A$222 (– 17%) US$0.60 A$1666 + A$333 (+ 25%)

Determination of Exchange Rates Price S D E US$0.75 Quantity of $A 8

Effects of Exchange Rate on BOP Demand for A$ comprises of all BOP CREDIT entries e.g. Exports (goods) Exports (services) Capital inflow (FDI in Australia) Supply for A$ comprises of all BOP DEBIT entries e.g. Imports (goods) Imports (services) Capital outflow (Australian FDI abroad)

Main Factors for the Value of the Australian Dollar World economic growth and the economic situation in the United States, Europe, Japan and other Asian countries World demand for commodities Australian real interest rates Special interest for foreign portfolio investors in Australia 10

Terms of Trade TTI > 100 Favourable TTI < 100 Unfavourable TTI = 100 Unchanged 11

Terms of Trade (2000–01 = 100) Source: ABS Catalogue 5302.0.

Causes and Effects of Changes in Terms of Trade Causes of deteriorating terms of trade Export prices Import prices Exchange rate movements Effects On the current account On the exchange rate On economic welfare